Identifying the Right “Depreciation” Tax Policy: The Most Boring – but Important – Article You Will Read Today

I’m normally reluctant to write about “depreciation” because I imagine eyes glazing around the world. After all, not many people care about the tax treatment of business investment expenses.

But I was surprised by the positive response I received after writing a post about Obama’s demagoguery against “tax loopholes” for corporate jets. So with considerable trepidation let’s take another look at the issue.

First, a bit of background. Every economic theory agrees that investment is a key for long-run growth and higher living standards. Even Marxist and socialist theory agrees with this insight (though they foolishly think government somehow is competent to be in charge of investments).

As you can see (click the chart to see a larger version), if we want people to earn more money, it definitely helps for there to be more investment. More “capital” means that workers have higher productivity, and that’s the primary determinant of wages and salary.

Indeed, one of the reasons why the right kind of tax reform will generate more prosperity is that double taxation of saving and investment is eliminated. With either a flat tax or national sales tax, economic activity is taxed only one time. No death tax, no capital gains tax, no double tax on dividends in either plan.

All of this background information helps underscore why it is especially foolish for the tax code to specifically penalize business investment. And this happens because companies have to “depreciate” rather than “expense” their investments.

If a company purchases a jet for $20 million, they should be able to deduct – or expense – that $20 million when calculating that year’s taxable income… A sensible tax system defines profit as total revenue minus total costs – including purchases of private jets. But today’s screwy tax code forces them to wait five years before fully deducting the cost of the jet (a process known as depreciation). Given that money today has more value than money in the future, this is a penalty that creates a tax bias against investment (the tax code also requires depreciation for purchases of machines, structures, and other forms of investment).

And I also addressed the issue when writing about the economic illiteracy in one of the Obama-Romney debates.

…a deal that cuts the corporate rate could end up doing more harm than good. The problem is that Congress and the Obama administration are thinking of pairing the rate cut with a slow-down of companies’ depreciation deductions. That’s a bad combination. A key goal of corporate tax reform should be to reduce the tax penalty on business investment. Investments in equipment, factories, and other forms of capital help power the long-run economic growth that boosts wages and living standards for American workers. …If depreciation is slowed down enough to offset the full revenue loss from the rate cut, then there’s no reduction in the investment penalty, on balance. The depreciation changes take back with the left hand everything that the rate cut gives with the right hand. …In fact, the policy makes the tax penalty on new investments bigger. …Why is this bad combination being considered? Maybe because the rate cut is easy to understand and the harm of slower depreciation is easy to overlook. …Yes, let’s cut the corporate tax rate. But, let’s not slow down depreciation to pay for it.

Margo Thorning of the American Council for Capital Formation adds some wisdom with her column in today’s Wall Street Journal.

…proposals that would increase the tax burden on capital-intensive industries—which are contributing to U.S. economic growth and employment—should be viewed with caution. …stretching out depreciation allowances reduces a company’s annual cash flow and raises the “hurdle rate” that new investments would have to meet before they are approved. For capital-intensive firms in sectors such as energy, manufacturing, utilities and transportation, the trade-off between delayed cash flow and lower corporate income-tax rates may result in cutbacks in capital spending. …Each additional $1 billion in investment is associated with 23,000 new jobs, according to data from the Department of Commerce and the Bureau of Labor Statistics. …Rather than drawing out depreciation schedules, a better, pro-growth approach to corporate tax reform would be to allow all investment to be expensed—in other words, deducted from income in the first year.

I share Margo’s concerns, which is why I’m very suspicious when the President says he wants to lower the corporate tax rate and “reform” the system.

Last but not least, Matt Mitchell (no relation) of the Mercatus Center recently added his two cents to the discussion.

The idea that “accelerated” depreciation is a loophole can be traced back to Stanley Surrey, the Harvard law professor whose work in the 1950s, 60s, and 70s influenced many…, including Senator Bill Bradley. …immediate expensing would mean abandoning “the attempt to tax business income.” That’s because it would essentially turn the corporate income tax into a corporate consumption tax. And that may be a good thing. Capital taxation is notoriously inefficient. This is one reason why Robert Hall and Alvin Rabushka permitted immediate 100 percent expensing in their famous flat consumption tax.

Anyhow, congratulations are in order. If you’ve made it this far, you almost surely know more about depreciation than every single politician in Washington. Though, to be sure, that’s not exactly a big achievement.

25 Responses

100% depreciation should be a no-brainer. Since government’s time-value of money is less than the value to businesses and especially for small businesses, it makes no economic sense to delay deductions that will eventually be completely written off.
Inventories should also be written off for tax purposes, with sales 100% taxable.
100% depreciation matches actual cash flow requirements and the time value of the tax benefit to the company is only the company’s effective tax rate on the asset.
This change will require that balance sheets continue to show approximate market value to accurately reflect the asset’s value to the company. For valuation purposes, it might simplify account requirements for all balance sheet valuation to use straight-line depreciation. Profit and loss statements should continue to match sales with cost for a true reflection of profitability.
Sales of such assets obviously become income to the company, so under-pricing to related parties might become a problem.
While Hall/Rabushka got most of it right, they disallow the write-off of existing value in partially depreciated assets. This would be a huge mistake. Between the time that such a tax change was proposed and when it went into effect, capital asset purchases would decline, waiting for better tax treatment.
Two final problems: Loses related to depreciation should only be carried forward. Next, if taxes on dividends are eliminated, either no dividends should be allowed from companies with losses or some provision should be made to tax distributions, with the tax applied against future tax liabilities.

Finally, Dan’s example of the corporate jet is a bad one, since it might make sense to further broaden the tax base by eliminating deduction of corporate toys. This does not mean that corporate helicopters, jets, apartments, sky boxes, and elaborate dinners would not be paid for by the corporation, only that they would not be deductible and would therefore come under increased scrutiny of the stockholders. The purpose should not be to increase tax revenues, but to lower tax rates.

Similar comments could be made about property taxes. Property taxes are not just double-taxation, but 10, 20, 30, or more taxation. If a company makes $1 and uses it to buy equipment, in states with personal property taxes the company will pay tax on the income, and then pay tax on the equipment bought every year for as long as it is in service, year after year. Furthermore, there is a huge record-keeping burden, as the company now has to track every capital investment it has ever made, for as long as they own that asset.

Mark Grohman: Sorry, I disagree. You’re saying that if someone spends his money on gambling, drinking, and prostitutes, he should pay the standard tax rate. But if he saves his money and leaves it to his children, he should pay a higher tax rate. The state should punish people who try to provide for their children and reward those who squander their wealth.

Fiddling with depreciation schedules can reward a politician’s friends and punish his enemies.

A great example is the tax depreciation periods for wind power and for nuclear power. Wind gets to write-off its capital over 3.5 years while a nuclear power plant needs 20.5 years. That makes a HUGE difference to investors in favor of wind.

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